World economy: EIU global forecast - Risk in MENA moves to forefront

November 16th 2017

FROM THE ECONOMIST INTELLIGENCE UNIT

The world economy is in its healthiest state for years. Monetary policy around the world remains extremely loose, inflation is low and commodities are cheap compared with a decade ago. Consequently, The Economist Intelligence Unit estimates growth of 2.9% in 2017, a significant increase from 2.3% in 2016. But we believe that these factors are fleeting and that the Chinese and US economies will soon show signs of capacity constraints, giving rise to inflation and adding to the cost of inputs for many consumer goods around the world. The pace of debt accumulation and faster inflation will, respectively, cause the People's Bank of China (the Chinese central bank) and the Federal Reserve (Fed, the US central bank) to act more aggressively, tempering economic growth. In addition, the European Central Bank (ECB) will begin to taper its quantitative easing (QE) purchases in 2018.

It also needs stressing that the effects on financial markets of withdrawing huge amounts of monetary stimulus are not well understood. QE on the scale seen in the past decade has never been attempted before and nor, therefore, has unwinding its effects. The Fed is trying to minimise the disruption by outlining a plan to reduce the value of its balance sheet. The ECB and the Bank of Japan are likely to follow this procedure. The current period of low volatility in financial markets is unlikely to be maintained throughout 2018‑22.

Two major events currently define our global outlook: a tightening of Chinese monetary policy in 2018 and the end of the US business cycle in 2020. We believe that the accumulation of debt in China is unsustainable. Our forecast assumes that the president, Xi Jinping, will sanction policies to rein in credit growth. Economic growth will slow by a full percentage point in 2018, to 5.8%. Given China's importance as an engine of global growth and demand, the ripple effects will be felt around the world, with exporters of hard commodities to China being the worst hit. Meanwhile, we expect that the long period of US economic growth will be interrupted in early 2020. At this point, the economy will be at full capacity and inflation will be accelerating, which will cause the Fed to signal a faster pace of rate increases. This pace will be greater than the economy can bear, triggering a contraction in private consumption and investment. The dip will be shallow and the rebound relatively rapid, owing to the Fed cutting interest rates aggressively along with support from government stimulus measures.

Although we have generally been revising our global trade forecasts upwards, we believe that global trade remains at risk from targeted protectionist measures, especially from the US and directed at China. If the administration of the US president, Donald Trump, decided to undermine the World Trade Organisation by unilaterally imposing restrictions on Chinese steel imports, using national security concerns as a reason for initiating trade protection, this could encourage other countries to do the same. However, the appetite for trade liberalisation still exists. The EU and Japan have emerged as key actors in this regard. At the latest round of talks in Vietnam, negotiators made progress on the so-called TPP‑11 (the Trans Pacific Partnership excluding the US), but agreement is yet to be reached in all areas.

Against the backdrop of a healthy global economy lies the highest level of political risk in years. The US is sending an ambivalent message to its traditional allies, following its withdrawal from the Paris climate agreement and the TPP, and its lukewarm stance towards NATO. But it is the US's heated rhetoric towards North Korea that could have the greatest potential consequences. Although both sides have a strong incentive not to escalate, we note the small risk of North Korea unleashing its nuclear capability under the belief that a US assault is imminent.

Political and security risks are also rising steadily in the Middle East. We expect the boycott of Qatar by some of the Gulf Co-operation Council (GCC) countries and Egypt to continue until at least 2021. Saudi Arabia is undergoing major changes that will alter the security balance of the region. The reformist young crown prince, Mohammed bin Salman al‑Saud, is rapidly consolidating power in the kingdom. In November he ordered the arrest of princes, ministers and businessmen under the auspices of an anti-corruption campaign. Crown Prince Mohammed bin Salman's ascent comes at a time of escalating tensions with a resurgent Iran. We expect the proxy conflict between the two countries to destabilise other nations, including Iraq, Syria and Lebanon.

Meanwhile, in Europe, the political mainstream has been given another chance to address the issues of income equality and national identity that have driven voters towards populist political parties. In Germany, the presence of the far-right Alternative for Germany in the Bundestag is a rebuke to Angela Merkel's immigration policy, but she remains chancellor. By endorsing Emmanuel Macron, French voters opted to give the centre another go at reviving the economy.

Developed world

The US economy is in good shape. However, wage growth has yet to take off despite the unemployment rate being at its lowest level since 2001. We expect the US economy to show signs of overheating soon, and to offset this the Fed will quicken the pace of monetary tightening, resulting in an economic downturn in early 2020. In the euro zone, political uncertainty surrounding the threat of Catalan secession from Spain has weighed on the currency. However, continued support and the likelihood of intervention from the ECB has significantly reduced concerns about the break-up of the union. The recent revival of the euro zone economy is likely to be sustained, although political risk will remain high. The UK economy has been resilient in the aftermath of the Brexit vote, but a heavy depreciation in the value of sterling has forced the Bank of England to increase interest rates at a time when the economy is weakening. Following the landslide secured by the ruling Liberal Democratic Party in Japan, Shinzo Abe is in a strong position to secure another term as prime minister when the party votes next in late 2018. This comes in the context of the mild recovery witnessed by Japan—its longest span of economic recovery since the 1980s. However, the QE adopted by the Bank of Japan (BOJ) is set to face problems, as the BOJ owns much of the government debt, reducing liquidity and distorting the market.

Emerging markets

The outlook for emerging markets in 2018‑19 is reasonable, with growth quickening to 4.6% from an estimated 4.4% in 2017. Brazil and Russia, the third- and fourth-largest emerging economies, will both grow again after lengthy recessions, and many economies will benefit from a double-digit rise in industrial commodity prices.

With China losing momentum, India will be Asia's fastest-growing large economy in 2018‑22, expanding at an average annual rate of 8%. Crucial to this is the government's bank recapitalisation plan, announced in October. Growth will also remain on track in the Association of South-East Asian Nations (ASEAN) member states, with an average annual expansion of 4.6%, compared with 4.7% in 2013‑17. Vietnam and Cambodia, in particular, will continue to record growth rates above 6%, owing to relatively low wage costs and advantageous geographic locations.

Brazil's recovery has helped to lift Latin America out of recession, after two years dominated by macroeconomic policy adjustment to the end of the commodities boom of the previous decade. With some notable exceptions, many countries have shifted to a monetary easing stance as inflation expectations subside. With the economy also strengthening in Argentina, international investor sentiment towards the region is improving. Combined with a rise in global risk appetite, as reflected in lower sovereign credit default swap rates (except for Venezuela), the major stockmarkets have been on a bull run.

Prospects for rapid economic growth in the Middle East and North Africa (MENA) remain stifled by heightened geopolitical risk, macroeconomic imbalances, policy uncertainty and corruption. Seven countries in the Middle East that collectively account for one-quarter of the population in the region are either torn by civil war or destabilised by Shia-Sunni rivalry. The GCC is now at the centre of a political crisis that could further erode investment and business prospects in the region. As the Saudi-Qatar situation continues to evolve, the conflict will enter a phase of unprecedented polarisation that is likely to shake up the alliances. We expect a general improvement in the region's economic outlook in 2018‑22, driven by Iran. Coupled with the positive impact of a broad commitment to improving business environments, this will enable faster growth. However, our assumption is that oil prices will not be sufficient to enable exporters to restore the expansionary fiscal policies that were in place in 2011‑14.

Following a dismal performance in Sub-Saharan Africa in 2016‑17, we expect only a lacklustre recovery to take hold in 2018‑22. With only patchy improvements in the external sector and further examples of economic mismanagement, we expect real GDP growth to pick up slowly, to 3%, in 2018, well below the average annual growth rate of 5.1% recorded in 2005‑15 and barely keeping pace with population growth.

Exchange rates

The US dollar has rallied since September, in response to ongoing signs of a strengthening economy. We expect the Fed to raise interest rates by about 200 basis points by early 2020, while slowly shrinking its balance sheet. Importantly, we believe that the Fed will maintain a similar policy stance under Jerome Powell, Mr Trump's nominee to succeed Janet Yellen as the Fed chair in 2018. The ECB is likely to start tapering its QE programme in 2018, although progress will be slow. The yen has gained ground against the US dollar in 2017, reflecting the BOJ's commitment to following a loose monetary policy.

Commodities

Global oil prices are expected to remain range-bound for dated Brent Blend, at around US$55‑65/barrel in 2018‑19 as OPEC's efforts to constrain global supply are offset by US shale, providing both a price ceiling and a floor. At their next meeting, OPEC members and their partners are expected to extend quotas until at least the third quarter of 2018, and potentially longer, to curb excess supply in the market. Industrial raw materials prices are set to rise for a second successive year in 2018. We expect food, feedstuffs and beverages prices to reflect subdued demand and a supply glut attributable to bumper harvests.